Wise Equine rules for smart equity investing
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Can financial assets give me stable returns like my horses?” asked X, a prospective client. I wondered if this was a trick question. Horses and stables conjured up images that were far removed from equity and debt.
X elaborated that he had been investing his money in horses for many years. He not only bet on them, but also bought and sold horses. However, he was getting a bit weary of this business and wanted to explore other investment options.
After conducting his financial plan, we recommended he invest a part of his portfolio in equity. To convince him, we drew several parallels between investing in stocks and horses. Like equity, you had to buy horses at a low price and sell high to make money. Like stocks, you had to keep emotions aside and not fall in love with your horses. Similarly, it was important to stay away from overvalued horses that had won few races, and invest in those with better pedigree, long-term prospects and racing history.
We also explained that equity investing was in many ways different from equine investing. It required specific skill sets to win in the stock market derby. Equity investing is not for the faint of heart. It requires a high level of persistence and perseverance, not to mention frayed nerves and sleepless nights.
Let’s not forget 21 January 2008, the Monday that battered the confidence of even the staunchest equity supporters. But those who weathered that storm saw the sun shine bright on their fortunes.
When we buy a stock, we behave like the owners of a company. Ownership entails we partake in the fortunes and misfortunes of the company. We must have some interest in the way a business operates, the challenges that it faces and how it sees through different business cycles to generate value for its shareholders. We must know how to read financial statements, understand how companies makes profit, evaluate risk taken by the management and how these can affect business in the future. We need to understand specific sectors, their cyclicality, and the socio-economic conditions of the country with respect to those sectors.
What does it take for someone to be successful in equity investing? By equity, I specifically refer here to single stock investments and not equity mutual funds. I believe you need three things to be successful: time, money and access to information.
Time: For most of us who hold day jobs, lack of time is the biggest impediment to investing consistently. Think about it. You come in to work and within a few minutes are barraged with calls from your broker about buying or selling some stock. You stall him saying you need to research them first. You pore through the company fundamentals over the day and get back to him with your decision. The broker calls you back in a few days about another hot stock. This time, you are preparing for an important meeting and have no time to entertain his call. You stall him a few more times and eventually lose interest. Stock investing is an intense activity, best left to those whose full-time job is to research and pick the right stocks, such as a fund manager in a mutual fund.
Money: If you invest in stocks, you must have a strategy in place. Random buying and selling without a plan is speculating, not investing. You may make some money on a few trades but you will find it hard to sustain your luck over longer periods. Often I find a random mishmash of 70 or 80 stocks in a portfolio, with no logical thinking or strategy supporting them. Sometimes the value of a single stock is a few thousand rupees in an overall portfolio of a few lakhs. Even if this stock were to perform spectacularly well, it will hardly move the needle on the overall value of the portfolio. Strategy is critical for providing direction to your convictions, be it about a sector or a theme. For example, your strategy could be to replicate an index. You need enough money to be able to buy the stocks in the index and hold them with similar weightages. You cannot execute this strategy with a few thousand rupees, or even a few lakhs.
Access to information: We live in an age of information overload. Often, we make hasty decisions based on what we read in the newspapers or what we see on television. Nothing could be worse than this form of investing. Markets react to news—whether good or bad—within minutes. By the time you read the news in the papers the next day or watch it on television later in the day, you are already too late. The stock’s price has already adjusted to the news much before you got wind of it.
In the short term, playing the stock market is a zero-sum game. For each stock that someone considered undervalued and purchased, there was someone who perceived it as overvalued and sold. Those who made money did so at the expense of those who lost money. The loser, obviously was someone who did not have the three fundamental attributes mentioned earlier. However, if you hold a well-managed, diversified portfolio of stocks over the long term, the zero-sum game does not apply. All investors will have made money over the long term, since the entire market appreciates over time.
At the end of this investing lesson, X acknowledged that he did not have the wherewithal to do his own stock picking. We told him we had a better solution for him—to invest in equity mutual funds, where a fund manager possessed all the skills necessary for managing a stock portfolio well.
“My precious mares would agree!” exclaimed a delighted X. “This way, I can retire and so can my horses.” We couldn’t agree more, especially since it came straight out of the horse’s mouth!
Priya Sunder is director and co-founder of PeakAlpha Investments.